Market Optimism Lingers On

The markets kick-started last week on a positive note, with each of the front-line indexes gaining between 1% and 1.8%, anticipating a Fed rate cut. The next two days were spent in a wait and watch mode with the indexes remaining largely flat. Contributing to the sharp intra day reversal on January 30^th after the Fed cut was the news of Fitch Ratings downgrading bond insurer FGIC (from AAA to AA).

However, the world's largest bond insurer MBIA reported that it has completed a $500M stock sale to Warburg Pincus (subsequent to reporting a staggering $2.3Bn Q4 loss, due to a $3.5Bn write-down on its insured credit derivatives portfolio) a part of the larger $1Bn investment the latter has committed to. This coupled with the news that a consortium of eight banks is working with New York State Insurance Commissioner Eric Dinallo, towards bailing out the troubled bond insurer Ambac Financial Group helped allay concerns that the next sector to fall prey to the sub-prime crisis would be the bond insurance sector. Positive sentiment was further heightened by Microsoft's unsolicited bid to acquire Yahoo Inc. for a whopping $44.6Bn. The markets showed strength for the last two days of the week, riding on the back of the above, enabling front-line indexes to post handsome weekly gains ranging between 3.7% and 4.9%.

[click all charts to enlarge]

Despite a strong re-surge from the 23rd January lows, the table below shows that the NASDAQ had its worst ever January while the S&P 500 index saw its sixth worst January in percentage terms.

The front line indexes are presently in a counter-trend rally as we had anticipated last week. Optimism over the passage of the stimulus plan by the Senate and the new found enthusiasm following Microsoft's (MSFT) bid for Yahoo (YHOO) will continue to buoy investor sentiment for at least some time next week. However, we believe that the ongoing rally is likely to be short-lived as the economy continues to face headwinds (highlighted below). We reiterate our outlook on the S&P 500 (currently at 1395) testing 1410-1440 levels.

Several global benchmark indexes have exhibited strong reversal patterns. It has been a while since the FTSE and DAX indexes penetrated their respective uptrend lines and the CAC 40 Index broke down from a classic head and shoulders pattern. These international indexes also commenced a pullback last week, rebounding from oversold levels. The rumblings of a slowdown in the global economy grew louder this week, as IMF trimmed forecast for world-wide growth to 4.1% from its October 2007 estimate of 4.4%, as tighter access to credit in the U.S. weighs on other assets and economies. Going by this revised estimate, the global economy will grow at its weakest pace since 2003.

The front line indexes are presently in a counter-trend rally as we had anticipated last week. Optimism over the passage of the stimulus plan by the Senate and the new found enthusiasm following Microsoft's (MSFT) bid for Yahoo (YHOO) will continue to buoy investor sentiment for at least some time next week. However, we believe that the ongoing rally is likely to be short-lived as the economy continues to face headwinds (highlighted below). We reiterate our outlook on the S&P 500 (currently at 1395) testing 1410-1440 levels.

Several global benchmark indexes have exhibited strong reversal patterns. It has been a while since the FTSE and DAX indexes penetrated their respective uptrend lines and the CAC 40 Index broke down from a classic head and shoulders pattern. These international indexes also commenced a pullback last week, rebounding from oversold levels. The rumblings of a slowdown in the global economy grew louder this week, as IMF trimmed forecast for world-wide growth to 4.1% from its October 2007 estimate of 4.4%, as tighter access to credit in the U.S. weighs on other assets and economies. Going by this revised estimate, the global economy will grow at its weakest pace since 2003.

In the sections below we review the Fed's decision, sift through the slew of economic data released over the past week and provide a mid-earnings season update.

The Fed Delivers

We had, on 30th January, anticipated that the Fed would cut interest rates by 50 bps, considering the bid rates under the TAF since the beginning of the week. Our call turned out to be just right. The Fed boldly cut rates by 50 bps on 30th January, in an attempt to stave off recession and "to promote moderate growth over time". The Fed noted that "financial markets remain under considerable stress, and credit has tightened further for some businesses and households" and "a deepening of the housing contraction as well as some softening in labor markets". This cut also served as an image booster for the Fed. After coming under much flak for its delayed response to the economic conditions and an emergency 75 bps rate cut on 22nd January, this rate cut finally signaled the Fed's seriousness in playing a proactive role in order to tackle the headwinds faced by the US economy. The Fed also let the door wide open for additional rate cuts, stating " downside risks to growth remain."

Earnings Report Card

We are right in the middle of the earnings season and for once, it can be said that earnings have taken a backseat, as macro economic conditions continue to hog the limelight. Of the constituent companies of the S&P 500, 282 companies have so far reported their Q4 earnings, with a respectable 59% beating estimates. While 27% missed the estimates, 14% reported earnings in-line with the expectations. The blended earnings growth rate for the S&P 500 in fourth-quarter of 2007 is projected to be -20.7%, a volte face from the 11.5% growth rate estimated at the start of the quarter.

The chart above provides a sector-wise snapshot of the hits and misses of all the 776 companies that have reported earnings for the December quarter since Aloca's report on 9th January marked the official start of the earnings season.

Economic Radar

The past week saw the release of a flurry of economic data. Durable goods orders clocked a 5.2% gain in December as against the 1.6% rise expected by economists, on the back of an increase in demand for computers and aircraft. Durable goods, excluding transportation rose 2.6%, indicating that capital spending continues. This also triggered hopes that robust export orders, will help avert a collapse in the manufacturing sector. The Institute for Supply Management's Manufacturing Index at 50.7 gained unexpectedly from its December reading at 48.40 - its first gain in seven months and an indication that U.S. factory activity showed a modest increase in January. With the exception of these indicators, all other data were gloomy.

Housing data released at the beginning of the week, continued to disappoint with new home sales falling to 12-year low levels, registering a 4.7% drop to 604,000 (a level last seen in Feb 1995). This drop in sales was in sharp contrast to the forecasted sales of 647,000. The December data ended a woeful year, that saw new home sales witness a 26.4% plunge for 2007. S&P/Case-Shiller's home price index, showed that home prices in 20 U.S. metropolitan areas fell 7.7% in November, for the 11th consecutive month. The decline is the biggest since the 20-city index was started in 2000. Economists were expecting a 7.1% drop.

The advance Q4 GDP numbers, released mid-week, showed that the growth almost came to standstill. The reading, which came in at 0.6% was half the street's consensus. The GDP report revealed widespread weakness in the economy, with the most obvious drag on growth being the ongoing housing rout. A decline in business inventories showed that companies cut back on inventories anticipating a slowdown and a lower output from the automotive plants were the other factors hampering growth. Yet another report showed that consumer spending – that contributes to nearly 67% of the total economy, rose a mere 0.2% in December (consensus: 2%) in the peak shopping season due to concerns over rising fuel prices and the non-availability of easy credit. This was a steep fall from 1% gain in November and marked the weakest rise since June 2006.

The most disconcerting piece of news stemmed from the non farm payrolls report released on Friday. The data showed that payrolls fell by as much as 17,000 in January vis-a-vis an upwardly revised increase of 82,000 jobs in December. This drop was the first decline in payrolls since August 2003 and provides one of the strongest indications that the economic expansion has slowed. The numbers sure confounded economists as the consensus of 80 economists surveyed by Bloomberg was for a gain of 70,000 jobs. We believe that this has certainly increased the odds of a recession and another rate cut in March. As of Friday's close, April Fed funds futures, traded on the CBOT showed a 70% chance that the Fed will cut rates by 50 bps at the next meeting scheduled for 18^th March.